If you are worried about your increased loan cost, owing to continuous rate hikes, and you are expecting a bonus this Diwali or a lump sum from some other source, here is one way to put it to good use: prepay your home loan partly. Even those of you who are not expecting a lump sum can use the part prepayment tool by paying small amounts at regular intervals.
We crunched numbers and found out that prepaying even small parts of your home loan would help you save money in the long run.
Part prepayment is done over and above your equated monthly instalments (EMIs). Says Satkam Divya, business head, Rupeetalk.com, a NetAmbit venture, “Whenever you make a part payment towards your loan, the payment goes towards repaying the principal amount of the loan. And when the principal amount goes down, the amount you pay as interest also goes down. Part payment has nothing to do with the current interest of the loan. Irrespective of high or low interest rates, if you have the money, you should go ahead and prepay or part pay the loan.”
Numbers tell the story
Part payment works for you whether you make a lump sum or regular payment. The bigger the amount you part pay, the lesser the total cost of the loan. Here are examples to explain how it works.
Case 1: When you make a lump sum payment.
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Suppose after a year of being in a loan, you make a lump sum payment of Rs 1 lakh on a loan of Rs 10 lakh taken at an interest rate of 11% for 20 years. Back-of-the-envelope calculations show that you will save about Rs 5 lakh in interest paid and your tenor will come down by at least five years. Here, it has been assumed that there are no prepayment charges after a year.
Case 2 : When you make regular part payments.
In the same example taken above, if you are not able to pay a lump sum but are instead paying regularly, you will still manage to save quite a bit.
Now if you pay Rs 10,000 every six months, starting from the 13th month of the loan, the net interest you pay would drop to about Rs 9.5 lakh from about Rs 14.77 lakh. Your saving comes to around Rs 5.26 lakh while your loan tenor gets reduced by six years and four months. Even if you assume a pre-payment fee of 2% on the sum of all prepayments made, the prepayment fee you pay is Rs 5,200. Even then, prepaying will save you Rs 5,21,209 over the same reduced tenor.
Things to keep in mind
When should you prepay? It is better to prepay in the initial years of the loan tenor since that’s when the principal outstanding is the maximum. In initial years, the principal amount constitutes a smaller part of the EMI as compared with the interest part.
Says Vipul Patel, director, Home Loan Advisors (HLA), an independent mortgage advisory firm, “Lenders usually have a six months lock-in till which you are not permitted to prepay or part pay.” For instance, HSBC Bank Ltd allows prepayment after at least six months of loan disbursal.
How much can you prepay? This varies from lender to lender. Patel says, “Most lenders allow you to prepay 25-90% of the outstanding loan amount per financial year.”
The minimum you can part pay is usually equal to at least a month’s EMI. Says Divya, “Banks usually allow you to part pay three to four EMI amounts, over and above your regular EMIs.”
How often can you prepay? You can either part pay regularly or pay a lump sum as is mentioned earlier in the story. Prepayment can also be done on a monthly basis, depending on the policy of the lender.
What’s the cost? The penalty of prepayment (full or part) again varies from lender to lender. Some banks have a different penalty amounts for full prepayment and part prepayment, others have a different penalty if you close the loan with your own sources and a different penalty if you’ve borrowed to make the prepayment (full or part).
Here are some examples. IDBI Bank Ltd’s website mentions its prepayment policy: “In case of prepayment/foreclosure of home loan from own source of funds, no prepayment charges will be levied. However, a prepayment fee of 2% on principal outstanding will be levied if prepayments are from sources other than your own.”
According to HSBC Bank’s website: “(If you pay) up to 25% of the loan amount sanctioned in every financial year, you will not be charged a penalty. For amount in excess of 25% of the loan amount sanctioned (the penalty) is 3% of amount prepaid.”
Then there are some banks, including Axis Bank Ltd and State Bank of India, that do not charge any penalty for prepay ment of loan in part or full.
Earlier this month, at the annual conference of banking ombudsmen held with Reserve Bank of India (RBI), the apex bank had asked banks not to charge prepayment fees on floating rate loans. Says Patel, “We wrote to our clients (lenders) if prepayment fees have changed, our clients confirmed that there is no change in their policy as far as pre-payment penalty goes as of now.”
Dilemmas you may face
Should you take another loan to prepay home loan? No, unless the new loan you are taking is cheaper than the home loan and it is unlikely to get such a loan.
It is always better to make part payments with your own funds. Says Divya, “Taking a loan to make part payments will not make sense unless the rate of interest of the loan is less than that what you are paying on the existing loan. For instance, taking a personal loan at 18% per annum to part-pay a loan with a rate of interest of 11% makes no sense.”
However, if there is a cheaper home loan in the market, you may consider a switch.
Should you invest surplus funds or prepay? The thumb rule is invest the surplus only if the investment gives you a guaranteed return that is 5% higher than your saving in case you had prepaid the loan (including the penalty).
Here, take the tax angle into account. You get an income-tax deduction under section 80C for repayment of the principal amount up to Rs 1 lakh and and deduction under section 24 for interest payment up to Rs 1.5 lakh for housing loan.
Most financial planners say that there are other instruments in the market that give tax benefit and if you can prepay or part prepay a home loan, go ahead and do so. The sooner you become debt-free the better.